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welcome to the best interest podcast
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where we believe Benjamin Franklin's
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advice that an investment in knowledge
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pays the best interest both in finances
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and in your life every episode teaches
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you personal finance and investing in
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simple terms now here's your host Jesse
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Kramer hello everybody and welcome to
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episode 52 of the best interest podcast
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my name is Jesse Kramer today we're
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going to talk about confidence
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overconfidence underconfidence different
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levels of confidence in investing and
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why it's such an important topic to talk
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about some people even think it's
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potentially the most important topic to
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talk about when it comes to individual
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investors people like you and me who are
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trying to save and invest money for the
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long run why does confidence matter so
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[Music]
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much
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okay investing requires a Goldilocks
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level of confidence not too hot not too
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cold you want to be somewhere in the
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middle right we want to have the
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confidence that the market will act in
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our favor in the long run right so we we
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look at historical data we try to
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evaluate probabilities we try to
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understand why stocks tend to go up over
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time convince ourselves that there's
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really this fundamental reason for that
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to occur right there's a fundamental
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reason for stocks to go up in the long
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run but we also need to have the
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humility to realize and the humility to
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know that we can't predict the shortterm
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movements of the market we look at stuff
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like Burton mul's evidence from a random
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walk down Wall Street which is an
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excellent book if you've never seen it I
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can throw a link in the show notes to a
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random walk down Wall Street we also
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look at stuff like the efficient market
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hypothesis the efficient market
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hypothesis states that some markets
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especially when there's more people
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involved in the market and more
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information about whatever's trading in
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that market that some markets approach
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what's called efficiency which means
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that they can take new information about
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the assets so let's look at like apple
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the stock market can take new
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information about Apple and synthesize
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that information so quickly that people
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will buy and sell the stock and the
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stock will repic to its correct value
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and that the market does that more more
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instantaneously and more accurately than
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any individual can do it on their own
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again that takes some humility to admit
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that the market is probably smarter than
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you in most cases of course there are
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some investors who disagree with the
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efficient market hypothesis and have the
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evidence to show have the track record
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to show that there might be holes in the
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efficient market hypothesis take a look
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at someone like Warren Buffett right
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Charlie Munger his partner they've
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beaten the market especially earlier in
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the career but even to today they've got
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a terrific track record against the
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market and they will look at the stock
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market and say efficient well not always
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there are lots of times where stocks are
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inefficiently priced where they're
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inaccurately priced and we're going to
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try to take advantage of that okay
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they're really smart guys they've been
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doing this a long time for them that's
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probably the right level of confidence
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but for joeo to have that opinion for
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joeo who's you know working 50 hours a
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week as a I don't know High School
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baseball coach and plumber he watches my
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Uncle Jim Kramer two nights a week and
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he thinks he's going to come out and do
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what Warren Buffett and Charlie Munger
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do that's overconfidence right we want
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to avoid that I mean this is the bare
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Market just like 2001 now on that topic
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we're going to switch gears and talk
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about this influential study that came
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out of the Columbia Business School
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Columbia University New York City and I
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think it was 2011 2012 somewhere in that
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range and the results of the study which
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again it's a social science study which
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especially recently they they tend to
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get frowned upon because the social
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sciences are notoriously hard to produce
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good evidence on you can't run a
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scientific experiment like you can in a
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lab where you have you know lasers and
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you're testing gravity and just the data
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is the data because in social sciences a
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lot of time you are relying on the way
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that people respond you're relying on
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people's opinions on the particular day
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that they sat down and did your study
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there might be cognitive or behavioral
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biases at play that push someone's
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answer in a certain direction and and
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can really lead to misleading results
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however this Columbia study has been
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rerun a few different times and the
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evidence appears to be really sound the
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results of the study are that men on
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average are
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overconfident they think they know more
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than they actually do and that women on
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average are underconfidence
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they think they know less than they
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actually do one of the important
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takeaways of this study is that the the
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scientists who who wrote it they called
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it honest overc confidence and honest
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underconfidence and it's so important
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it's because these men and these women
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in the study and the men and the women
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that you are interacting with in your
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daily life and maybe even some of you
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men and women who are listening to this
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you honestly believe that you know all
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these things you do so like take men for
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example they're honestly
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overconfident someone might whatever 30%
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50% overconfident in terms of their
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knowledge and they they honestly believe
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it though they honestly believe it and
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it's not until you kind of sit down and
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they able to show them through some sort
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of objective facts that they don't know
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as much as they do until you show them
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that they are going to continue to
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believe that they know more than they do
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and we have to ask ourselves questions
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like how does that play out in the real
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world and how does that play out in
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investing we're going to get into some
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of those answers but first I want to
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share just some interesting anecdotes
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from male and female confidence through
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my work here on the best interest
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through interacting with readers through
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my work at my my professional work now
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right I work for a fiduciary wealth
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management firm in Rochester New York
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and I sit down with people every single
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day and talk to them about their
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personal finances about their investing
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and I'm not surprised especially after
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seeing this study it's something that
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I've kind of felt intuitively anyway and
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I'm sure many of you have felt it
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intuitively anyway that yeah if someone
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is going to be overconfident in a
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conversation especially about something
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like stocks or investing it's probably
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going to be a guy it's going to be a man
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right and if someone's underconfidence
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or timid or or afraid to take a stance
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that person seems more likely to be a
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woman and and that's the anecdotal data
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that I have for sure because when people
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come to my office and they are asking
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about individual stock names when
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they're questioning the reason for
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diversification when they're talking
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about using leverage right you using
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leverage means you take a bet and then
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you borrow someone's money to increase
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the size of your bet if you win you win
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really big and if you lose you basically
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lose all your money and sometimes even
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more sometimes you lose someone else's
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money so it's really risky to use
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leverage those kind of conversations
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that I have at at work they are 10 or 20
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times more likely to happen with a with
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another man than with a woman but when I
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do have conversations with women which
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is pretty often and it's getting more
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often and I think it's awesome those
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conversations are more likely to contain
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statements like I don't even know where
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to begin or I've never been able to do
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this stuff meaning like Finance or
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investing or I've never felt comfortable
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with numbers and I don't know where to
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start or to be honest with you Jesse I
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don't even care if I'm in the room I
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just want you to take care of it all for
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me because I'm never going to understand
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this stuff and sometimes I I would just
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want to pause and call a timeout and say
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you know what it is totally fine if if
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you really are uncomfortable with math
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or if you're really uncomfortable with
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these topics I don't want want to force
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them down your throat I don't want to
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make you feel anxious that I'm that I'm
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forcing you to learn this stuff but a
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lot of this stuff is doable right a lot
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of this stuff is something that if you
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sit down and you you listen to some
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podcasts hey you you read some blogs you
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read some books you you follow some news
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you can start to pick up some of the
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basics it doesn't necessarily mean that
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you have to act on that stuff right one
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of the problems of of overconfidence is
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that some people will watch as I said
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earlier my Uncle Jim Kramer he's not my
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real Uncle but they'll watch Uncle Jim
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Kramer and they'll say yep I'm now ready
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to be a stock picker I'm going to go do
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it well time out you watched Uncle Jim
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Kramer for two hours a week for three
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months and now you think you're ready to
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take on Wall Street like that's classic
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overconfidence but having watch those
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three months of Uncle Jim Kramer that's
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better than knowing nothing and you
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obviously learned something and and
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hopefully you've learned enough to know
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that you have much more to learn but
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you've learned enough to say yeah I'm
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I'm I'm reasonably comfortable having a
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conversation about investing
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so going back to the way we started this
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conversation confidence is a Goldilocks
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scenario there's a Goldilocks zone where
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you don't want to be too confident so
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confident that you just choose to do
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something stupid but you also don't want
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to be underconfidence where you just
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kind of sit there on your hands and
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believe that you're never going to learn
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this stuff or or you're so scared that
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you never take any action in the first
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place right that's another thing that
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it's a shame and and and it's something
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I see all the time and I do my best to
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help people with is this idea of someone
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says you know what I think the stock
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market's a Ponzi scheme I've seen the
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headlines I've never really learned
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about it but I I think it's fraud and
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any kind of investing is fraud I don't
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even really well now with Silicon Valley
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Bank which by the way we covered a
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couple episodes ago I I don't even think
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banks are legitimate anymore I'm just
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going to stuff my cash underneath the
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mattress like whoa that amount of fear
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to me at least shows a a a really too
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much underconfidence and and someone's
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going to choose to to throw money under
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their mattress when it's like there are
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much much better options you don't have
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to go all in on the stock market right
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there's a middle ground there's a gold
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loock zone for every investor out there
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part of my mission on the best interest
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what I try to do with at work so we try
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to understand an individual's risk
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tolerance we try to understand how
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someone thinks what they know we want to
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educate them further as much as we can
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and then we want to advise them whether
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they go off on their own or whether they
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use us at work we want to inv them on
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the right portfolio construction for
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them the right amount of risk to take
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the right amount of reward to expect how
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to put their financial plan together
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that kind of
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[Music]
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thing let's switch gears real quick cuz
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we're going to bring in some Outsiders
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not as guests per se but I'm going to
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read from some of the stuff they've
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written about overconfidence
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underconfidence just The Confidence Game
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in general when it comes comes to
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investing and this comes from a
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gentleman named Larry Sedro Larry is an
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icon in the advisory and investment
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business he's very wellknown he's an
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excellent writer I think he's written 17
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books and from this article which I'll
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I'll throw the the link in the show
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notes Larry writes the biggest risk
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confronting most investors is staring at
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them in the mirror boom what a what a
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statement the biggest risk guys it's not
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a bank failing it's not interest rates
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going up it's not that you make the
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wrong stock picks or maybe it is only if
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the reason why you made the wrong stock
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picks is staring you in the mirror the
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biggest risks to most investors is
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themselves and it often has to do with
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their confidence or lack thereof in
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their own decision-making and Larry
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talks about some cool research for
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example and I'm just going to go through
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Bullet by Bullet rather than than adding
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too much commentary people tend to be
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over optimistic about their life
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prospects and that optimism directly
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affects their final and their financial
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decisions overconfidence has been
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documented among experts and
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professionals including corporate
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Financial officers as well as
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professional Traders and investment
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bankers right overconfidence happens
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everywhere overconfidence includes a few
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different phenomena one for example is
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called overplacement
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overplacement is when you overestimate
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your rank in a population on some
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positive Dimension classic example would
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be if I asked you hey on a scale of 0 to
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100 how smart are you like what
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percentage of people are You Smarter
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then overestimation is when someone says
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I'm probably smarter than 75% of the
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population when really they're only
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smarter than
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60% so overplacement is just one example
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of the way overconfidence works and it's
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when you just you think you're better
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smarter better looking jump higher
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whatever it is you think you're better
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than you are now over Precision is
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another type of overconfidence and it's
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where you overestimate the accuracy of
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your beliefs and you say something like
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hey what's the S&P 500 going to finish
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at at the end of this year and you say
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yeah I'm pretty sure it's going to
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finish at
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$422 and the reason why is because I ran
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this analysis like that's a very very
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precise estimate and there's no way that
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any person can really believe that
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estimate to that level of precision but
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where does this overconfidence come from
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right now there's one cognitive process
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that really support courts where
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overconfidence comes from and it's
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called the self- attribution bias this
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is something that came from the research
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of Amos tki and Danny Conan won a Nobel
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Prize Danny Conan wrote a famous book
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called Thinking Fast and Slow really
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well-known guys especially in the fields
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of Behavioral Finance behavioral
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economics now self- attribution bias
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occurs in all people right it's
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something that we have to be able to
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recognize in ourselves and hopefully
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combat and it occurs when people credit
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their own talent and abilities for past
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success while blaming their failures on
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bad luck okay in other words when
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investors get something right they tend
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to say yep that was me that was my
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decision and now I'm I'm pretty
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confident in my decision- making because
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cause and effect I made that decision I
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got it right boom I'm confident but then
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when that same investor gets something
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wrong they tend to fail to downgrade
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their own confidence right they say well
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no no see my my call was still right but
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it's it's just bad luck that Ford had
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that malfunction at their plant and they
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stopped producing cars that day and the
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stock went down that that's not on me
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that's that's just bad luck when I got
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it right it was on me that was my good
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stuff but when I get stuff wrong it's
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just bad luck well no wonder
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overconfidence occurs in that scenario
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if you blame all the bad things in your
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life on bad luck you know you're not
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taking responsibility for the things in
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your life and and you're going to end up
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overconfident now how does this
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overconfidence manifest itself in the
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way investors act individual investors
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trade individual stocks actively right
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and on average they lose money by doing
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so and the more someone actively trades
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due to overconfidence the more money
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they typically lose Studies have shown
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that the stocks that individual
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investors buy they tend to subsequently
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underperform the market whereas the
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stocks that individual investors sell
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tend to outperform the market right
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individual overconfident investors are
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buying the losers and selling the
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winners the exact opposite of what you
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want to do then we can look at something
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like actively managed mutual funds that
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charge High fees without delivering the
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the high performance that we'd expect
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from them and and that shows even
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further evidence that even expert
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individual investors in active funds
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tend to be overconfident about their
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ability to to select High performing
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stocks or maybe maybe if it's a
00:16:03
investment adviser they're overconfident
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in their ability to select High
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performing
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managers now studies show that men as we
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already talked about earlier are more
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overconfident than women in decision
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domains especially those that are
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traditionally perceived as masculine one
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of which is financial matters what we're
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talking about here today that
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overconfidence leads to more action you
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know in this realm action equates to
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trading and one study found that
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consistent with higher confidence on the
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part of men the average turnover for
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accounts opened by men is about one and
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a half times higher than for accounts
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opened by women turnover means trading
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right men trade one and a half times
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more than women and as a result men pay
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almost 1% more per year in higher
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transaction costs and their net of fee
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returns are far lower than women so
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that's what Larry Sedro has to say about
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overconfidence
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not only where it comes from but also
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how it affects us in our investing lives
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and now I'm pulling from a second writer
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here his name is Rob enan and he writes
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on a Blog a Canadian blog Rob is
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Canadian he writes on a Blog called
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Boomer and Echo and I'm having to reach
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out to Rob because I don't know why brog
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is called Boomer and Echo and maybe I
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should but Rob writes overconfidence is
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something that most investors have to
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deal with at some point in their journey
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and Rob argues that they're actually two
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types of overconfident investors now the
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first is kind of what we already talked
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about and that's when you believe that
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your past investing performance has more
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to do with your skill in decision-
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making than with luck or timing or
00:17:38
market conditions now the second type of
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overconfidence we haven't quite touched
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on it yet but it is similar and that
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occurs when you believe that you can
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correctly predict a future outcome and
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then you make active decisions with your
00:17:51
Investments to support that belief now
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we'll come back to the second one the
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first type of overconfidence you you can
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avoid that or combat that by comparing
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your investment returns with an
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appropriate Benchmark with an
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appropriate index so if I'm trying to
00:18:08
beat the stock market and I'm investing
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say in like mostly large cap US stocks
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that you've all heard of I need to
00:18:15
compare my results to the S&P 500 and
00:18:17
say am I actually doing better are my
00:18:20
investment thesis actually playing out
00:18:24
very few people actually take notes on
00:18:26
why they're investing in what they're
00:18:28
investing in most investors I talk to
00:18:30
who just decide to throw money at this
00:18:32
stock or that stock they do it because
00:18:34
they say oh I've heard of Facebook oh I
00:18:36
saw it in the news like that's such a
00:18:37
poor reason at the very least you should
00:18:40
have some fundamental rationale for why
00:18:42
you're investing and then you can
00:18:43
compare your decisions against reality
00:18:45
and you can compare your results against
00:18:47
the S&P 500 now the second type of
00:18:50
overconfidence that we talked about
00:18:52
let's give an example there so that type
00:18:54
of overconfidence is essentially
00:18:56
predicting the future and then making
00:18:59
investment decisions according to your
00:19:01
prediction it's saying something like
00:19:03
you know what I bet Co is going to come
00:19:05
back in the next eight months and
00:19:07
because of that I'm gonna buy more zoom
00:19:10
and I'm gonna buy more pelaton and I'm
00:19:13
gonna I'm gonna buy all the things that
00:19:14
worked out the first time in covid and
00:19:16
I'm going to sell all the things that
00:19:18
didn't do well the first time in covid
00:19:19
just because I I I read a study and it
00:19:21
said CO's coming back so boom there's a
00:19:23
macro prediction about the future of the
00:19:26
world and then I'm going to adjust my in
00:19:28
Ms accordingly this type of
00:19:30
overconfidence is is really hard to
00:19:32
overcome because we as humans we love
00:19:36
making predictions about the future we
00:19:38
love listening to experts who make smart
00:19:41
informed predictions about the future or
00:19:43
at least have some sort of interesting
00:19:45
facts to back up their predictions and
00:19:47
then even if we don't personally have a
00:19:50
strong opinion about the future it's
00:19:52
pretty easy for us to be swayed by what
00:19:55
someone else says and then the way we've
00:19:57
been swayed write the way that our
00:19:59
opinions have been affected it's pretty
00:20:01
understandable that those opinions will
00:20:03
trickle down into our investing
00:20:06
decisions so personally this is what I
00:20:10
do and and what Rob does too to fight
00:20:12
this type of overc confidence is to
00:20:15
invest in some
00:20:17
Diversified bucket of Investments
00:20:20
predetermined asset allocation with
00:20:22
rules in place for when to rebalance and
00:20:25
what I mean by that is my IRA assets are
00:20:28
80% in Diversified stock funds 10% in
00:20:32
Diversified bond funds 10% in
00:20:34
Diversified alternative funds no matter
00:20:37
what 801010 is my target allocation I
00:20:40
don't really care what the future of the
00:20:42
world is I don't really care if CO's
00:20:44
coming back my timeline is long I'm not
00:20:46
worried about macro events in general
00:20:49
and I let those funds do the
00:20:51
diversification for me so with that kind
00:20:54
of asset allocation
00:20:56
portfolio you can pay attention mention
00:20:58
to what the underlying Holdings are but
00:21:00
you don't really need to right what you
00:21:03
really need to do is look at your
00:21:04
overall performance you can rebalance as
00:21:06
needed to your targeted mix you can even
00:21:09
set up rules in your accounts you know
00:21:11
you can set up a rule at Fidelity at
00:21:12
Vanguard at Schwab to say hey when this
00:21:15
801010 asset allocation gets out of
00:21:17
whack by more than say 3% I want you to
00:21:21
rebalance sell a little bit of the over
00:21:23
performers buy a little bit of the
00:21:25
underperformers get back to 801010
00:21:28
you don't even have to think about it
00:21:30
right you don't really care what the
00:21:31
future is you're humble enough you're I
00:21:34
mean we have to go back to the beginning
00:21:35
now right we got to go full circle
00:21:37
you're confident enough to invest your
00:21:39
money you're confident enough to pick an
00:21:42
asset allocation based on your age and
00:21:44
your timeline your risk tolerance all
00:21:46
that good stuff but you're humble enough
00:21:49
to know that you can't really predict
00:21:51
the future you're humble enough to know
00:21:53
that when your asset allocation gets out
00:21:55
of whack you need to Rin it back in and
00:21:57
bring it back into balance it's a mixx
00:22:00
it's a Goldilocks mix not too hot not
00:22:02
too cold not too overconfident not too
00:22:05
underconfidence and again one of my
00:22:07
goals here on the best interest one of
00:22:09
the things that I think is so cool about
00:22:11
financial education and financial
00:22:13
literacy is that over time I really
00:22:16
believe that it it pushes your
00:22:18
confidence into that right Zone you know
00:22:22
I work with people and it's very very
00:22:24
common for a couple things to happen
00:22:25
it's very common for people who
00:22:27
basically are at Step Zero to be
00:22:29
underconfidence
00:22:58
it's that honest overconfidence and they
00:22:59
say no offense Jesse I know more than
00:23:03
you and your co-workers
00:23:04
know okay let's have that conversation I
00:23:07
am I'm totally up for that conversation
00:23:09
I want to hear your points of view but
00:23:10
I'm going to push back because you're
00:23:12
going to have to prove it to me and I'm
00:23:15
not going to be afraid to prove you
00:23:16
wrong usually because it's in your best
00:23:19
interest if I do so right if I let that
00:23:21
honest overconfidence slide and you walk
00:23:23
out of here thinking that you're going
00:23:24
to take over the investing World odds
00:23:27
are you aren't and if you really know
00:23:29
what you're doing I'll be like wow you
00:23:31
are extremely educated on this sure go
00:23:33
for it but 99 times out of a 100 that
00:23:36
honest overconfidence is true
00:23:38
overconfidence and it needs to be tamed
00:23:41
it needs to be brought back to reality
00:23:43
for your own
00:23:45
good okay so the benefit of financial
00:23:49
education one of the things I love he
00:23:51
about the best interest is that over
00:23:53
time your confidence is going to end up
00:23:56
right in that sweet gold Bly lock Zone
00:23:58
where you want it to be the confidence
00:24:00
to take some action to invest your money
00:24:03
to understand that it's the right thing
00:24:04
to do in the long run the confidence to
00:24:07
diversify your money to build a
00:24:08
long-term portfolio to identify your
00:24:10
financial goals and invest accordingly
00:24:13
but then the humility or the lack of
00:24:15
confidence to say I can't really predict
00:24:17
what the Market's going to do tomorrow
00:24:19
and if I need to predict what the
00:24:20
Market's going to do tomorrow I am not
00:24:22
allowed to take that much risk right
00:24:24
those are some humble statements and you
00:24:26
need to have both if you want to be a
00:24:28
good
00:24:29
[Music]
00:24:30
investor thanks for tuning in to this
00:24:33
episode of the best interest podcast if
00:24:35
you have a question for Jesse to answer
00:24:37
on a future episode send him an email at
00:24:39
Jesse bestin interest. blog again that's
00:24:43
Jesse at bestin interest. blog did you
00:24:46
enjoy the show subscribe rate and review
00:24:49
the podcast wherever you listen this
00:24:51
helps others find the show and invest in
00:24:53
knowledge themselves and we really
00:24:55
appreciate it we'll catch you on the
00:24:57
next episode of the best interest
00:25:00
[Music]
00:25:02
podcast the best interest podcast is a
00:25:04
personal podcast met for education and
00:25:07
entertainment it should not be taken as
00:25:09
Financial advice and is not prescriptive
00:25:11
of your financial
00:25:13
situation